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that these exemptions apply only at the federal level; therefore, it remains in-
cumbent on the entrepreneur to be cognizant of complying with state “Blue
Sky” laws, or the state statutes enacted to protect investors from insubstan-
tial securities offerings. For early-stage deals, the Regulation D exemption
offers an ideal approach, especially for those offers of less than $1 million,
since they are least mired in legal provisions and requirements. For example,
Rule 504 allows companies a way to raise up to $1 million in a 12-month pe-
riod without having to be subject to federal requirements, although the com-
pany is still obligated to notify the SEC of its offering.
In private placements, business owners receive cash for equity, and they
can choose from a menu of financing options. In some cases, debt and equity
can be mixed to create a funding solution. Furthermore, the private place-
ment can include all kinds of financing not publicly sold:

Senior debt. Lowest cost financing from banks or insurance companies,
generally a loan on a first priority status secured by company assets.
Subordinated debt. Higher interest rate than senior debt in exchange for
higher risk (paid after senior debt is paid), sometimes packaged with
warrants (“sweeteners”).
Subscription warrant. A security that can be converted into or ex-
changed for a company™s stock.
Preferred stock. Pays a dividend to the holder and usually includes more
The Solution: The Private Placement

rights than common stock (in bankruptcy, considered junior to debt)
and can be converted into common stock.
Common stock of the company.

While all these financing options are feasible, after the dot-com debacle,
we see angel investors inclined toward preferred stock. Why preferred stock?
Here are some reasons: (1) Preferred stock is senior to common stock, pro-
viding leverage to influence management when things “go south”; (2) it re-
quires the entrepreneur to remain in contact with the investor; (3) it provides
warning mechanisms permitting the investor to make changes in the man-
agement or act to protect the investment; (4) it can provide for income on the
investment in the form of dividends; (5) it is redeemable by the corporation,
for example, through a sinking fund with compulsory repayment; and (6) it
offers the investor convertibility to common stock so that the investor can
share in growth.
Private placement investments, in fact, consist of anything that is not a
public offering. Such leeway lets money-raisers exercise the limits of their
creativity and negotiating skills. Herein lies the strength of the private place-
ment, and the main difference between an institutional private placement in-
vestment and direct, participatory investment by an angel. The former is
primarily debt; the latter is not. A private placement usually means a subor-
dinated debt transaction in the institutional market, but for angels it usually
means an equity transaction between an individual and the company, a
transaction that brings with it several advantages and responsibilities.
A private placement investment has the advantages of confidentiality
and lower cost. First, with their less stringent disclosure requirements, direct
investments enable private investors”who keenly prize their privacy”to
maintain confidentiality in their financial transactions. Second, reduced cost
figures prominently in choosing direct investment, especially in comparison
with public offerings. For instance, the cost of a private placement invest-
ment (i.e., a capitalization transaction handled directly by the company) is
markedly less than the cost of a public offering, or even a SCOR.
Also, with most early-stage investing, private placement deal structures
tend to be equity or equity-related, including the ability to accommodate
subordinated debt. Even when subordinated debt or convertible debt is in-
volved, these structures offer convertibility into equity so that the investor
can share in the upside possibilities should the venture become successful.
The private placement offers flexibility during negotiations between the
private investor and the entrepreneur, a flexibility unavailable when pur-
chasing stocks of public companies. Don™t forget, in the case of early-stage
ventures, that the company, its management, and strategy, even its technol-
ogy, are unproven. From the investors perspective, the seed or start-up in-

vestment is the riskiest investment in the private equity alternative asset class.
Undeveloped and underdeveloped technology, unproven management, and
unpenetrated or undeveloped markets all spell risk. It is precisely for these
reasons that investors seek to manage risk early on by negotiating through
the private placement terms that make such risk more palatable, if not en-
tirely manageable.
Finally, other benefits also derived by the entrepreneur from use of the
private placement include (1) a more rapid time frame for concluding the fi-
nancing when compared with direct public offerings and other alternative of-
fering structures; (2) more than just the capital invested in the form of the
knowledge, experience, and contacts brought to the table by angel investors
in the deal; and (3) the proven fact that private placements have historically
accommodated smaller transactions, the size of the transactions in which
most early-stage entrepreneurs are involved.
The private placement is many times primarily perceived by entrepre-
neurs in its legal aspects. This myopic view misses the marketing aspects in-
herent in offers to private investors on an individual basis. The private
placement is more limited than its public offering cousins, and by virtue of
this is less formal and more targeted. The range of resources available to
guide the entrepreneur on the legal aspects of private placement is wide, and
we mention a few in Appendix B. We emphasize the market aspects of ex-
empt offerings based on our experience raising early-stage capital. And our
bias, albeit cynical, is rooted in experience: keep lawyers out of the process as
long as you can but never close a deal without their counsel. As you will see
in the next section, savvy entrepreneurs will be those prepared to identify
multiple avenues for raising the capital that they seek, including angels and
other nontraditional capital resources.


As an inventor, entrepreneur, or owner of a small but rapidly growing busi-
ness hungry for capital, you must ask if nontraditional resources will suit
your deal. For ventures at the preseed, seed, R&D, start-up, or expansion
stages, a vast array of financing methods are available. After tapping one™s
own finances, and that of family, friends, and other founders, and perhaps
having exhausted the bootstrap financing option, what alternative sources
remain? Even a partial list can seem confusing: academic institution research
financing, community loan development funds, technology licensing, venture
leasing, transaction purchase order, corporate investment by strategic part-
ners, incubator-based financing, and of course angels and venture capital.

• Operating deficit • Working capital • Fixed assets
• Equipment • Acquisitions


The business has higher risk with uncertain return The business is low risk The business can offer a high return
• Weak cash flow • High leverage • Strong cash flow • Low leverage • Growth • Niche market
• Low growth • Unproven management • Audited financials • Good management • Good management
The Solution: The Private Placement



Less than $100,000 More than $100,000 START-UP RAPID GROWTH ESTABLISHED

• Banks • Leasing • Banks • Finance companies • Investor group • Public offering
• Factoring • Finance companies • Institutions (private placement) • Venture capital • Private placement
Limited growth High
• Leasing companies potential growth • Private placement
potential • Wealthy individuals
• Venture capital
• Incubator
Exhibit 2.1 Selecting the Right Capital Source

The question is, which is most appropriate for your deal? Exhibit 2.1 helps
answer this question.
The first decision involves clarifying the financing need. If a company
has working capital, fixed assets, and equipment, then more traditional eq-
uity or debt sources of capital are in order. However, if an operating deficit
exists, or if the company possesses no revenues, only alternatives to tradi-
tional financial sources seem reasonable, as illustrated in the chart.
Another decision involves determining whether the business will appeal
to an equity or debt source of capital, a decision determined primarily by risk
and return. If the business can offer a high return, more traditional equity
sources seem feasible. This alternative requires the presence of a large, or
rapidly growing, established market for the company™s product or service, a
clear niche market, and seasoned management with a strong track record of
success. If, on the other hand, the business offers a low risk, debt becomes
appropriate, using traditional sources of financing. To qualify for traditional
debt financing, you must have demonstrated cash flow to service debt, low
leverage on the balance sheet, audited financials by a CPA firm, and experi-
enced management with a positive record of good credit histories. However,
if the business offers high risk with uncertain returns”as do many entrepre-
neurial ventures because of a weak cash flow, a high leverage in terms of a
large amount of debt, a low growth rate, or an unproven management
team”nontraditional financing resources remain the only option.
If, however, the business can offer high return and low risk, it can focus
on what type of equity or what type of debt to establish. If the debt transac-
tion involves less than $100,000, perhaps private investors might be inter-
ested. But most likely the entrepreneur would turn first to banks or finance
companies. In more cases, however, private investors get involved in equity
transactions. But an established company, or a company demonstrating
rapid financial growth, will be attractive to the institutional equity markets
and/or public market, making appropriate the traditional sources of capital.
But for a start-up with limited growth possibility (i.e., a company without
the ability to reach annual sales figures of $50 million to $60 million) only
nontraditional financial resources seem appropriate.
Examining Exhibit 2.1 should help you establish the suitability of a pri-
vate placement for your venture.


In later chapters, we report results of our study in which private investors de-
scribe what they look for in a deal. Investors™ decisions may seem idiosyn-
cratic, their motivations diverse. They are. But this diversity merely reflects
The Solution: The Private Placement

their characteristic individuality. Do not overlook their underlying concur-
rence: They share far more than may seem apparent. You will also see that
what we advise here fits with what investors say they look for in a venture.
What follows, then, are things to think about in making your deal finance-
able (Exhibit 2.2).
Management team experience is crucial. An astute investor has said, “If
the critical element in a successful real estate transaction is ˜location, loca-
tion, location,™ the critical element in a successful business endeavor is
˜management, management, management.”™ In determining if your deal is fi-
nanceable, consider the quality of the managers, their references, the extent
to which the team is complete, whether they have worked together as a team,
their past success in the venture™s industry, and the relevance of their back-
grounds to the entrepreneurial task at hand. Especially in an early-stage ven-
ture, experience in the industry far exceeds the importance of functional
expertise. The venture needs a CEO who understands the industry, its mar-
ket, and the application of its underlying technology more than it needs a fi-
nancial expert, operations officer, or advertising maven.

EXHIBIT 2.2 Is Your Deal Financeable?

Management team . . . . . . . . . . . . . . . . . . . . . . . . . . “
”Requisite skills, driven, worked together, chemistry, experience in industry, pride
in enterprise
Large market size (qualified buyers and unique market niche) . . . . . . . . . . . . . “
Market readiness + need + product appeal . . . . . . . . . . . . . . . . . . . . . . . . . “
”Is missionary selling required?
Competition understood . . . . . . . . . . . . . . . . . . . . . . . . . . . . “
”Current”future (3“7 years)
”Barriers (beyond price)
Established or emerging industry . . . . . . . . . . . . . . . . . . . . . . . . . . “
Protected proprietary technology . . . . . . . . . . . . . . . . . . . . . . . . . . “
”A real solution
Does it work? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . “
Production can be currently performed . . . . . . . . . . . . . . . . . . . . . . . . . . . “
Channel economics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . “
”Demonstrate understanding of cost to bring product/service to market
High margins (at least 15%, pretax) . . . . . . . . . . . . . . . . . . . . . . . . “
Above average profit potential . . . . . . . . . . . . . . . . . . . . . . . . . . . . “
Capital intensity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .“
Reasonable projections . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . “
Valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . “
Clear and believable exit plan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . “

Source: International Capital Resources

Market size must be calculated. Assess the size of the market, specifically
whether the total number of potential customers in the target market share is
substantial enough to generate the revenues stipulated in the marketing plan.
Consider whether there are there enough qualified buyers to provide rev-
enues and subsequent return to investors? This calculation needs to be not
only accurate but demonstrable. Entrepreneurs need to demonstrate that
they understand exactly who their customers will be and describe knowledge
and understanding of these customers. Investors also have an inclination to-
ward rapidly growing markets and markets that will continue to grow.
Market readiness should be considered as well. Will the technology or
product require missionary selling, the kind that convinces people they need
it? Missionary selling, of course, will increase the cost and expand the time
needed to bring the product to market.
Competition must not be underestimated. Although many entrepreneurs
will insist that none exists, every compelling venture has a direct or indirect
competitor. More to the point, however, is not the immediate competition
but the competition that will surely emerge within three to five years. The
discerning entrepreneur anticipates the inevitable competition and the re-
sources those competitors may bring to bear on the market, and also
contemplates the barriers that the entrepreneur can erect to the competitor™s
entry into the market. A clear understanding of the competitive marketplace
is paramount in order to be taken seriously by an investor. Poor analysis can


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